Watching the detectives of the stock market can help to answer questions

Are short sellers immoral parasites or clever analysts who help to expose ‘frauds, fads and failures’?

Tue, Jul 15, 2014, 01:05

To many, attempting to profit from stock market falls is immoral and parasitic. Short sellers, however, see themselves as the detectives of the stock market, an argument that has been greatly strengthened by their exposure of fraud at Spanish wifi firm Gowex.

Gowex had long been the darling of the Spanish stock market, its value soaring from €49 million in 2010 to a peak of €1.9 billion in April. However, its success story smelt fishy to Gotham City Research, a secretive New York firm renowned for its aggressive approach. A fortnight ago, following eight months of research, Gotham published a 93-page report accusing Gowex of fraud. Days later, chief executive Jenaro Garcia fessed up, and the firm filed for bankruptcy.

It was a stunning victory for Gotham, given the renown with which Gowex was held in Spain. As recently as March, Garcia was lauded by Spanish prime minister Mariano Rajoy, who said society “needs entrepreneurial examples like you” and presented him with a “well-deserved” business prize.

Garcia had previously received an award for innovation at Ernst & Young’s Entrepreneur of the Year programme, while the country’s fund managers – the professionals who are meant to do their homework before committing investors’ money – had also missed numerous red flags.

One such warning sign, according to Gotham’s report, was the fact that Gowex’s auditor did not have a business email address and apparently worked out of one room in an apartment. Gowex paid auditing fees of just €52,798 in 2012 – a paltry figure for a company with declared revenues of €114 million.

Ironically, the report’s publication only prompted the Spanish regulator to warn it would investigate Gotham for potential “market abuse”. Little wonder, then, Gotham founder Daniel Yu views the entire debacle as one that “completely validates the critical role that short selling plays in the financial markets and the fact that regulators’ initial response should not be to shoot the messenger”. Short sellers, says Gotham, help expose “frauds, fads and/or failures”.

Many examples back up that case. Short seller Jim Chanos, for example, famously exposed accounting irregularities at Enron back in 2000, and was also prescient in the run-up to the global financial crisis.

He also claims to have warned the G7 finance ministers in April 2007 – 17 months before the Lehman bankruptcy – that banks’ toxic assets were a danger to the global financial system, a message that was “completely and officially ignored”.